Brexit vote will have a tricky outcome

The threat of secession has dogged both European governments and the region as a whole for the last four years. Greece has come perilously close to leaving the euro a number of times since 2012, Scottish voters rejected a proposition to leave the United Kingdom in 2014, and 80 percent of those who voted in Spain’s Catalonia region said they would like to be an independent state in a non-binding poll the same year.

British Prime Minister David Cameron has promised to hold a referendum on EU membership by the end of 2017, and Credit Suisse believes the vote will likely take place this summer. But first, Cameron has promised to negotiate with other European countries to reform the union and change the terms of the UK’s membership.

The prime minister has been meeting with European leaders for months on the subject, and formally made his case at a December 18 dinner in Brussels. He has spent much of the new year traveling to European capitals for last-minute negotiations ahead of a February 12 European Council meeting to discuss his five demands.

The first demand is that the EU more explicitly protects the sovereignty of its member states by changing the Treaty of Lisbon, essentially the European constitution, to allow member countries to opt out of a clause that calls for them to move toward an “ever closer union.” Second, Cameron would also like to see the balance of power shift back toward individual member states, with fewer regulations emanating from Brussels.

Third, the prime minister has said he would like a governance structure that ensures that EU members that aren’t in the euro are treated fairly on issues that affect access to Europe’s single market. Fourth, he wants the EU to become more economically competitive by cutting what he considers excessive regulation and bureaucracy, moving aggressively toward trade deals with the United States and others, and removing protectionist policies within the single market.

The final demand is the most fraught: he wants the UK to have the right to refuse certain welfare benefits to migrants, which some say flouts anti-discrimination laws. Michael O’Sullivan, Credit Suisse’s Chief Investment Officer for International Wealth Management, believes Cameron will ultimately be able to strike a deal that will convince a majority of his countrymen that staying in the European Union is better than leaving.

There are plenty of arguments to support that view. A so-called Brexit would cost the UK access to Europe’s single market and force new trade negotiations. Europe, which buys 45 percent of British exports and supplies 53 percent of its imports, is Britain’s largest trading partner. Britain would also lose the ability to influence EU rules and regulations that affect the single market.

From an investor’s perspective, the British pound is the asset most vulnerable to turbulence ahead of the referendum. Indeed, O’Sullivan believes separation anxiety is already weighing on the pound, which has fallen 5 percent in trade-weighted terms since November. The pound would surely fall further in the event of a Brexit, but a yes vote could spur the Bank of England to raise interest rates, putting upward pressure on the currency.

Paradoxically, UK gilt prices may rise heading into the referendum and, in the event of a no vote, as investors flee to relatively safe assets. If Britain votes to stay in the union, however, those “safe-haven” seekers would likely sell their bonds in relief and look for better deals elsewhere. (Courtesy: The Financialist)